Most people in America have some kind of debt. I don’t know why, but these days, it seems to be rampant. Keep in mind that debt can be in the form of a mortgage, a car loan, a student loan, credit card balances, etc. Basically, anything that you have borrowed money for is considered debt. Having debt can be good for you as long as you don’t overdo it and are diligently working to pay it off.
Let me stop here for a minute and clarify things a bit. I think I just lost a few people here because they’ve been told that debt is evil and you should never have it. Well, that’s completely wrong. Having debt allows you to build an established payment history. This history allows companies to see how responsible you’ve been with your debt payments. If you’ve done a good job at keeping up with your payments and not just paying the minimums then you’ve probably built yourself a really good credit rating. This credit history is very important and will allow you to buy a car, a house, or other items using credit.
Calculate Your Debt Ratio
What is a debt ratio and how do you calculate it? In layman’s terms a debt ratio is the process in which you compare how much you make, also known as income, with how much you’re spending (i.e. debt).
This isn’t complicated at all and is very easy to do. What you want to do is add up all your monthly payments such as credit cards, car loans, bank loans, etc. Everything that has a payment due date and can be reported to a credit agency needs to be included in this list.
Then add up all your income sources, such as paychecks, alimony, or any other money that you receive on a monthly basis.
Now that you have your monthly debt and income calculated, you divide your total monthly debt by your total monthly income calculated above. Multiply this number times 100 to get your debt to income ratio. This process is the same one that banks used to determine your credit worthiness.
What is a Good Debt to Income Ratio?
When it comes to debt, the lower your overall debt ratio is the better. Now there are two types of debt, good and bad.
On the other hand, bad debt is considered anything that you finance which is just consumed and does not appreciate and value. This kind of debt is what creates a bad financial situation. Credit should never be used to purchase everyday items such as food, clothes, gas, etc.
Here’s the caveat, if you’re very diligent about paying off your credit cards every single month so that you have zero balance, then it is okay to use your credit cards to buy food, clothes, and any other regular expense. A good debt to income ratio for bad debt ratio should be less than 10% of your monthly income.
Your total debt to income ratio, when looking at that and good debt together, should be 36% or lower. Anything higher than 36% is considered to be risky for creditors and a ratio over 40% is considered to be a potential financial disaster.
If after reading this you determine that you have way too much debt, it’s not the end of the world. You can still change your situation by putting a plan together and paying it down. When paying down your debt make sure that you focus on your bad debt first. Once you have paid down your debt, it will give you some additional money and will also make managing your finances easier. The second thing it will do is improve your credit score.
Do you have too much debt?